Economists typically assess the “fair market value” of a house based upon its rental rate for so-called “housing services”—the actual benefits of living in a house. But to use the rental rate is to do what Larry Summers called “ketchup economics”; 40-ounce bottles of ketchup sell for exactly twice what 20-ounce bottles do, therefore the ketchup market is fair and efficient. (In fact even this is not true, since ketchup is sold under bulk pricing. This reminds me of a rather amusing situation I recently encountered at the grocery store: The price of individual 12-packs of Coke was $3, but you could buy sets of five for $10 each. This meant that buying five was cheaper in total—not just per unit—than buying four. The only way to draw that budget constraint is with a periodic discontinuity; it makes a sawtooth across your graph. We never talk about that sort of budget constraint in neoclassical economics, yet there it was in front of me.)

When we value houses by their rental rate, we’re doing ketchup economics. We’re ignoring the fact that the rent is too damn high—people should not have to pay as much as they do in order to get housing in this country, particularly housing in or near major cities. When 44% of Americans are forced to spend over a third of their income just fulfilling the basic need of shelter, something is wrong. Only 60% of the price of a house is the actual cost to build it; another 20% is just the land. If that sounds reasonable to you, you’ve just become inured to our absurd land prices. The US has over 3 hectares per person of land; that’s 7.7 acres. A family of 3 should be able to claim—on average—9 hectares, or 23 acres. The price of a typical 0.5-acre lot for a family home should be negligible; it’s only 2% of your portion of America’s land.

And as for the argument that land near major cities should be more expensive? No, it shouldn’t; it’s land. What should be more expensive near major cities are buildings, and only then because they’re bigger buildings—even per unit it probably is about equal or even an economy of scale. There’s a classic argument that you’re paying to have infrastructure and be near places of work: The former is ignoring the fact that we pay taxes and utilities for that infrastructure; and the latter is implicitly assuming that it’s normal for our land ownership to be so monopolistic. In a competitive market, the price is driven by the cost, not by the value; the extra value you get from living near a city is supposed to go into your consumer surplus (the personal equivalent of profit—but in utility, not in dollars), not into the owner’s profit. And actually that marginal benefit is supposed to be driven to zero by the effect of overcrowding—though Krugman’s Nobel-winning work was about why that doesn’t necessarily happen and therefore we get Shanghai.

There’s also a more technical argument to be had here about the elasticity of land supply and demand; since both are so inelastic, we actually end up in the very disturbing scenario in which even a small shift in either one can throw prices all over the place, even if we are at market-clearing equilibrium. Markets just don’t work very well for inelastic goods; and if right now you’re thinking “Doesn’t that mean markets won’t work well for things like water, food, and medicine?” you’re exactly right and have learned well, Grasshopper.

So, the rent is too damn high. This naturally raises three questions:

Why is the rent so high?

What happens to our economy as a result?

What can we do about it?

Let’s start with 1. Naturally, conservatives are going to blame regulation; here’s Business Insider doing exactly that in San Francisco and New York City respectively. Actually, they have a point here. Zoning laws are supposed to keep industrial pollution away from our homes, not keep people from building bigger buildings to fit more residents. All these arguments about the “feel” of the city or “visual appeal” should be immediately compared to the fact that they are making people homeless. So 200 people should live on the street so you can have the skyline look the way you always remember it? I won’t say what I’d really like to; I’m trying to keep this blog rated PG.

Similarly, rent-control is a terrible way to solve the homelessness problem; you’re created a segregated market with a price ceiling, and that’s going to create a shortage and raise prices in the other part of the market. The result is good for anyone who can get the rent-control and bad for everyone else. (The Cato study Business Insider cites does make one rather aggravating error; the distribution in a non-rent-controlled market isn’t normal, it’s lognormal. You can see that at a glance by the presence of those extremely high rents on the right side of the graph.)

Most people respond by saying, “Okay, but what do we do for people who can’t afford the regular rent? Do we just make them homeless!?” I wouldn’t be surprised if the Cato Institute or Business Insider were okay with that—but I’m definitely not. So what would I do? Give them money. The solution to poverty has been staring us in the face for centuries, but we refuse to accept it. Poor people don’t have enough money, so give them money. Skeptical? Here are some direct experimental studies showing that unconditional cash transfers are one of the most effective anti-poverty measures. The only kind of anti-poverty program I’ve seen that has a better track record is medical aid. People are sick? Give them medicine. People are poor? Give them money. Yes, it’s that simple. People just don’t want to believe it; they might have to pay a bit more in taxes.

So yes, regulations are actually part of the problem. But they are clearly not the whole problem, and in my opinion not even the most important part. The most important part is monopolization. There’s a map that Occupy Wall Street likes to send around saying “What if our land were as unequal as our money?” But here’s the thing: IT IS. Indeed, the correlation between land ownership and wealth is astonishingly high; to a first approximation, your wealth is a constant factor times the land you own.

Remember how I said that the average American holds 7.7 acres or 3 hectares? (Especially in economics, averages can be quite deceiving. Bill Gates and I are on average billionaires. In fact, I guarantee that Bill Gates and you are on average billionaires; it doesn’t even matter how much wealth you have, it’ll still be true.)

Interpolating the ones I couldn’t easily find data on, I estimate that these 102 landowners (there were ties in the top 100) hold a total of 30 millionacres, of the 940 million acres in the United States. This means that 3% of the land is owned by—wait for it—0.000,03% of the population. To put it another way, if we confiscated the land of 102 people and split it all up into 0.5-acre family home lots, we could house 60 million households—roughly half the number of households in the nation. To be fair, some of it isn’t suitable for housing; but a good portion of it is. Figure even 1% is usable; that’s still enough for 600,000 households—which is to say every homeless person in America.

One thing you may also have noticed is how often the word “family” comes up. Using Openoffice Calc (it’s like Excel, but free!) I went through the whole top 100 list and counted the number of times “family” comes up; it’s 49 out of 100. Include “heirs” and “estate” and the number goes up to 66. That doesn’t mean they share with their immediate family; it says “family” when it’s been handed down for at least one generation. This means that almost two-thirds of these super-wealthy landowners inherited their holdings. This isn’t the American Dream of self-made millionaires; this is a landed gentry. We claim to be a capitalist society; but if you look at who owns our land and how it’s passed down, it doesn’t look like capitalism. It looks like feudalism.

Indeed, the very concept of rent is basically feudalist. Instead of owning the land we live on, we have to constantly pay someone else—usually someone quite rich—for the right to live there. Stop paying, and they can call the government to have us forced out. We are serfs by another name. In a truly efficient capitalist market with the kind of frictionless credit system neoclassicists imagine, you wouldn’t pay rent, you’d alwayspay a mortgage. The only time you’d be paying for housing without building equity would be when you stay at a hotel. If you’re going to live there more than a month, you should be building equity. And if you do want to move before your mortgage ends? No problem; sell it to the next tenant, paying off your mortgage and giving you that equity back—instead of all that rent, which is now in someone else’s pocket.

Because of this extreme inequality in land distribution, the top landholders can charge the rest of us monopolistic prices—thus making even more profits and buying even more land—and we have little choice but to pay what they demand. Because shelter is such a fundamental need, we are willing to pay just about whatever we have in order to secure it; so that’s what they charge us.

On to question 2. What happens to our economy as a result of this high rent?

In a word: 2009. Because our real estate market is so completely out of whack with any notion of efficient and fair pricing, it has become a free-for-all of speculation by so-called “investors”. (I hate that term; real investment is roads paved, factories built, children taught. What “investors” do is actually arbitrage. We are the investors, not them.)

A big part of this was also the deregulation of derivatives, particularly the baffling and insane “Commodity Futures Modernization Act of 2000” that basically banned regulation of derivatives—it was a law against making laws. Because of this bankers—or should I say banksters—were able to create ludicrously huge amounts of derivatives, as well as structure and repackage them in ways that would deceive their buyers into underestimating the risks. As a result there are now over a quadrillion dollars—yes, with a Q, sounds like a made-up number, $2e15—in nominal value of outstanding derivatives.

Because this is of course about 20 times as much as there is actual money in the entire world, sustaining this nominal value requires enormous amounts of what’s called leverage—which is to say, debt. When you “leverage” a stock purchase, for example, what you’re doing is buying the stock on a loan (a generally rather low-interest loan called “margin”), then when you sell the stock you pay back the loan. The “leverage” is the ratio between the size of the loan and the amount of actual capital you have to spend. This can theoretically give you quite large returns; for instance if you have $2000 in your stock account and you leverage 10 to 1, you can buy $20,000 worth of stock. If that stock then rises to $21,000—that’s only 5%, so it’s pretty likely this will happen—then you sell it and pay back the loan. For this example I’ll assume you pay 1% interest on your margin. In that case you would start with $2000 and end up with $2800; that’s a 40% return. A typical return from buying stock in cash is more like 7%, so even with interest you’re making almost 6 times as much. It sounds like such a deal!

But there is a catch: If that stock goes down and you have to sell it before it goes back up, you need to come up with the money to pay back your loan. Say it went down 5% instead of up; you now have $19,000 from selling it, but you owe $20,200 in debt with interest. Your $2000 is already gone, so you now have to come up with an additional $1,200 just to pay back your margin. Your return on $2000 is now negative—and huge: -160%. If you had bought the stock in cash, your return would only have been -5% and you’d still have $1900.

My example is for a 10 to 1 leverage, which is considered conservative. More typical leverages are 15 or 20; and some have gotten as high as 50 or even 70. This can lead to huge returns—or huge losses.

But okay, suppose we rein in the derivatives market and leverage gets back down to more reasonable levels. What damage is done by high real estate prices per se?

Well, basically it means that too much of our economy’s effort is going toward real estate. There is what we call deadweight loss, the loss of value that results from an inefficiency in the market. Money that people should be spending on other things—like cars, or clothes, or TVs—is instead being spent on real estate. Those products aren’t getting sold. People who would have had jobs making those products aren’t getting hired. Even when it’s not triggering global financial crises, a market distortion as large as our real estate system is a drain on the economy.

The distorted real estate market in particular also has another effect: It keeps the middle class from building wealth. We have to spend so much on our homes that we don’t have any left for stocks or bonds; as a result we earn a very low return on investment—inflation-adjusted it’s only about 0.2%. So meanwhile the rich are getting 4% on bonds, or 7% on stocks, or even 50% or 100% on highly-leveraged derivatives. In fact, it’s worse than that, because we’re also paying those rich people 20% on our credit cards. (Or even worse, 400% on payday loans. Four hundred percent. You typically pay a similar rate on overdraft fees—that $17.5 billion has to come from somewhere—but fortunately it’s usually not for long.)

Most people aren’t numerate enough to really appreciate how compound interest works—and banks are counting on that. 7%, 20%, what’s the difference really? 3 times as much? And if you had 50%, that would be about 7 times as much? Not exactly, no. Say you start with $1000 in each of these accounts. After 20 years, how much do you have in the 7% account? $3,869.68. Not too shabby, but what about that 20% account? $38,337.60—almost ten times as much. And if you managed to maintain a 50% return, how much would you have? $3,325,256.73—over $3.3 million, almost one thousand times as much.

The problem, I think, is people tend to think linearly; it’s hard to think exponentially. But there’s a really nice heuristic you can use, which is actually quite accurate: Divide the percentage into 69, and that is the time it will take to double. So 3% would take 69/3 = 23 years to double. 7% would take 69/7 = 10 years to double. 35% would take 69/35 = 2 years to double. And 400% would take 69/400 = 0.17 years (about 1/6, so 2 months) to double. These doublings are cumulative: If you double twice you’ve gone up 4 times; if you double 10 times you’ve gone up 1000 times. (For those who are a bit more numerate, this heuristic comes from the fact that 69 ~ 100*ln(2).)

Since returns are so much higher on other forms of wealth (not gold, by the way; don’t be fooled) than on homes, and those returns get compounded over time, this differential translates into ever-increasing inequality of wealth. This is what Piketty is talking about when he says r > g; r is the return on capital, and g is the growth rate of the economy. Stocks are at r, but homes are near g (actually less). By forcing you to spend your wealth on a house, they are also preventing you from increasing that wealth.

Finally, time for question 3. What should we do to fix this? Again, it’s simple: Take the land from the rich. (See how I love simple solutions?) Institute a 99% property tax on all land holdings over, say, 1000 acres. No real family farmer of the pastoral sort (as opposed to heir of an international agribusiness) would be affected.

I’m sure a lot of people will think this sounds unfair: “How dare you just… just… take people’s stuff! You… socialist!” But I ask you: On what basis was it theirs to begin with? Remember, we’re talking about land. We’re not talking about a product like a car, something they actually made (or rather administrated the manufacturing of). We’re not even talking about ideas or services, which raise their own quite complicated issues. These are chunks of the Earth; they were there a billion years before you and they will probably still be there a billion years hence.

That land was probably bought with money that they obtained through monopolistic pricing. Even worse, whom was it bought from? Ultimately it had to be bought from the people who stole it—literally stole, at the point of a gun—from the indigenous population. On what basis was it theirs to sell? And even the indigenous population may not have obtained it fairly; they weren’t the noble savages many imagine them to be, but had complex societies with equally complex political alliances and histories of intertribal warfare. A good portion of the land that any given tribe claims as their own was likely stolen from some other tribe long ago.

It’s honestly pretty bizarre that we buy and sell land; I think it would be valuable to think about how else we might distribute land that didn’t involve the absurdity of owning chunks of the planet. I can’t think of a good alternative system right now, so okay, maybe as a pragmatic matter the economy just works most efficiently if people can buy and sell land. But since it is a pragmatic justification—and not some kind of “fundamental natural right” ala Robert Nozick—then we are free as a society—particularly a democratic society—to make ad hoc adjustments in that pragmatic system as is necessary to make people’s lives better. So let’s take all the land, because the rent is too damn high.

[First of all, let me apologize for missing last week’s post. It was quite a week for me; the weekend itself (actually Wednesday to Sunday) was taken up by Gen Con, after which I had my four-day road trip back to Long Beach, and then of course I had to unpack, clean my apartment, stock my refrigerator and so on. Now that I’m settled in back in Long Beach, I should be able to resume my regular blogging schedule. Classes start on Monday, but I won’t let that stop me.]

But it’s important to keep in mind that the reason this bother us, the reason it is so shocking and aberrant, is that the latter half of the 20th century and the start of the 21st have been the most peaceful period in recorded history. Technology notwithstanding, the level of violence we are seeing now would not have been out of place in the Middle Ages; even if they’d had a world news broadcast media it would have given these events only minor attention.

It’s also interesting to see how neoclassical economists try to understand the phenomenon of war. Right-wing economists who think that humans are rational are completely baffled by war, because it cripples infrastructure and kills millions of people (as neoclassical economists would say, “depreciation of human capital”, as though human beings were a special case of machinery), basically the opposite of what an economy is supposed to do.

Krugman is more sensitive to the irrationality of human behavior than most neoclassicists, and as a result he does proportionally better; Krugman recognizes that war is done for political, not economic reasons. But as neoclassical Keynesians are wont to do, he doesn’t look deeper; human behavior is assumed to be a minor deviation from the infinite identical psychopath, rather than a fundamentally different paradigm.

Think about it: Why would it be that leaders become more popular when they start wars, especially if war is economically damaging? Shouldn’t people be angry at a leader who insists upon risking their lives and destroying their wealth?

To be fair, some are; anti-war protest is about as old as war. But the vast majority of people in the vast majority of wars have supported their leaders, sometimes even saying things like “I disagree with this war, but we must all stand together in order to win it.” If you think that humans are rational self-interested optimizers, this sort of behavior must seem absolutely nonsensical.

But it makes perfect sense once you realize what humans actually are. We’re not selfish. We’re also not altruistic, not in the broadest sense. We are tribal. We identify ourselves with a group, our tribe, and then act to advance the perceived interests of that group.

What tribe we choose can vary, even within one person: You can have varying degrees of solidarity (remember how I said solidarity can be quantitatively formalized?) with your family, your friends, your school, your home town, your state, your nation, your race, your culture, your religion, your species. You can be torn between these different identities when their interests conflict. At the two extremes lie your own self-interest and the interests of all sentient beings in the universe; one measure of your moral development as an individual is how much time you can spend toward the latter end rather than the former.

When a leader declares war, he—it is usually a ‘he’, though Margaret Thatcher is a notable exception—is either expressing that tribal instinct or capitalizing upon it. For examples of each, look no further than George W. Bush, who really believed in avenging 9/11 and toppling Saddam Hussein, and Dick Cheney, who saw the Iraq War as a great way to raise the value of Halliburton stock. (Among living people, Dick Cheney is the closest I can think of to a neoclassical rational agent. Among the dead, I think I’d go with Josef Stalin. Look upon your ‘rationality’ and despair.)

The good news is, we actually are beginning to succeed. The process is slow and painful, and there are setbacks—2014 was definitely a setback—but still, we do make progress. We have expanded our notion of tribes over time, far beyond its original capacity. We evolved for a tribe of about 100 people, barely above what we’d now call “friends and family”; we now unite ourselves into nation-states of hundreds of millions or even billions. The very fact that I can say “China did X” and not be speaking utter nonsense is proof that humanity has made it quite far along the continuum toward universal altruism. We have already advanced seven orders of magnitude; we have less than one left before we include the entire human species. Another two or three after that, and we’ll have encompassed all sentient life on Earth. Another five or six past that, the galaxy; then another nine and we may well have the whole damn universe. 7 down, 18 to go.

Don’t lose hope; this year’s violence is an anomaly in the trend toward peace.

No, I am none of those things. I guess if you insist on labeling, you could call me a “cognitivist”; and in terms of policy I tend to agree with the Keynesians, but I also like the Modern Monetary Theorists.

But really I think this sort of labeling of ‘schools of thought’ is exactly the problem. There shouldn’t be schools of thought; the universe only works one way. When you don’t know the answer, you should have the courage to admit you don’t know. And once we actually have enough evidence to know something, people need to stop disagreeing about it. If you continue to disagree with what the evidence has shown, you’re not a ‘school of thought’; you’re just wrong.

The whole notion of ‘schools of thought’ smacks of cultural relativism; asking what the ‘Keynesian’ answer to a question is (and if you take enough economics classes I guarantee you will be asked exactly that) is rather like asking what religious beliefs prevail in a particular part of the world. It might be worth asking for some historical reason, but it’s not a question about economics; it’s a question about economic beliefs. This is the difference between asking how people believe the universe was created, and actually being a cosmologist. True, schools of thought aren’t as geographically localized as religions; but they do say the words ‘saltwater’ and ‘freshwater’ for a reason. I’m not all that interested in the Shinto myths versus the Hindu myths; I want to be a cosmologist.

At best, schools of thought are a sign of a field that hasn’t fully matured. Perhaps there were Newtonians and Einsteinians in 1910; but by 1930 there were just Einsteinians and bad physicists. Are there ‘schools of thought’ in physics today? Well, there are string theorists. But string theory hasn’t been a glorious success of physics advancement; on the contrary, it’s been a dead end from which the field has somehow failed to extricate itself for almost 50 years.

So where does that put us in economics? Well, some of the schools of thought are clearly dead ends, every bit as unfounded as string theory but far worse because they have direct influences on policy. String theory hasn’t ever killed anyone; bad economics definitely has. (How, you ask? Exposure to hazardous chemicals that were deregulated; poverty and starvation due to cuts to social welfare programs; and of course the Second Depression. I could go on.)

The worst offender is surely Austrian economics and its crazy cousin Randian libertarianism. Ayn Rand literally ruled a cult; Friedrich Hayek never took it quite that far, but there is certainly something cultish about Austrian economists. They insist that economics must be derived a priori, without recourse to empirical evidence (or at least that’s what they say when you point out that all the empirical evidence is against them). They are fond of ridiculous hyperbole about an inevitable slippery slope between raising taxes on capital gains and turning into Stalin’s Soviet Union, as well as rhetorical questions I find myself answering opposite to how they want (like “For are taxes not simply another form of robbery?” and “Once we allow the government to regulate what man can do, will they not continue until they control all aspects of our lives?”). They even co-opt and distort cognitivist concepts like herd instinct and asymmetric information; somehow Austrians think that asymmetric information is an argument for why markets are more efficient than government, even though Akerlof’s point was that asymmetric information is why we need regulations.

Marxists are on the opposite end of the political spectrum, but their ideas are equally nonsensical. (Marx himself was a bit more reasonable, but even he recognized they were going too far: “All I know is that I am not a Marxist.”) They have this whole “labor theory of value” thing where the value of something is the amount of work you have to put into it. This would mean that labor-saving innovations are pointless, because they devalue everything; it would also mean that putting an awful lot of work into something useless would nevertheless somehow make it enormously valuable. Really, it would never be worth doing much of anything, because the value you get out of something is exactly equal to the work you put in. Marxists also tend to think that what the world needs is a violent revolution to overthrow the bondage of capitalism; this is an absolutely terrible idea. During the transition it would be one of the bloodiest conflicts in history; afterward you’d probably get something like the Soviet Union or modern-day Venezuela. Even if you did somehow establish your glorious Communist utopia, you’d have destroyed so much productive capacity in the process that you’d make everyone poor. Socialist reforms make sense—and have worked well in Europe, particularly Scandinavia. But socialist revolution is a a good way to get millions of innocent people killed.

Sraffians are also quite silly; they have this bizarre notion that capital must be valued as “dated labor”, basically a formalized Marxism. I’ll admit, it’s weird how neoclassicists try to value labor as “human capital”; frankly it’s a bit disturbing how it echoes slavery. (And if you think slavery is dead, think again; it’s dead in the First World, but very much alive elsewhere.) But the solution to that problem is not to pretend that capital is a form of labor; it’s to recognize that capital and labor are different. Capital can be owned, sold, and redistributed; labor cannot. Labor is done by human beings, who have intrinsic value and rights; capital is made of inanimate matter, which does not. (This is what makes Citizens United so outrageous; “corporations are people” and “money is speech” are such fundamental distortions of democratic principles that they are literally Orwellian. We’re not that far from “freedom is slavery” and “war is peace”.)

Neoclassical economists do better, at least. They do respond to empirical data, albeit slowly. Their models are mathematically consistent. They rarely take account of human irrationality or asymmetric information, but when they do they rightfully recognize them as obstacles to efficient markets. But they still model people as infinite identical psychopaths, and they still divide themselves into schools of thought. Keynesians and Monetarists are particularly prominent, and Modern Monetary Theorists seem to be the next rising star. Each of these schools gets some things right and other things wrong, and that’s exactly why we shouldn’t make ourselves beholden to a particular tribe.

Monetarists follow Friedman, who said, “inflation is always and everywhere a monetary phenomenon.” This is wrong. You can definitely cause inflation without expanding your money supply; just ramp up government spending as in World War 2 or suffer a supply shock like we did when OPEC cut the oil supply. (In both cases, the US money supply was still tied to gold by the Bretton Woods system.) But they are right about one thing: To really have hyperinflation ala Weimar or Zimbabwe, you probably have to be printing money. If that were all there is to Monetarism, I can invert another Friedmanism: We’re all Monetarists now.

Finally, Modern Monetary Theorists understand money better than everyone else. They recognize that a sovereign government doesn’t have to get its money “from somewhere”; it can create however much money it needs. The whole narrative that the US is “out of money” isn’t just wrong, it’s incoherent; if there is one entity in the world that can never be out of money, it’s the US government, who print the world’s reserve currency. The panicked fears of quantitative easing causing hyperinflation aren’t quite as crazy; if the economy were at full capacity, printing $4 trillion over 5 years (yes, we did that) would absolutely cause some inflation. Since that’s only about 6% of US GDP, we might be back to 8% or even 10% inflation like the 1970s, but we certainly would not be in Zimbabwe. Moreover, we aren’t at full capacity; we needed to expand the money supply that much just to maintain prices where they are. The Second Depression is the Red Queen: It took all the running we could do to stay in one place. Modern Monetary Theorists also have some very good ideas about taxation; they point out that since the government only takes out the same thing it puts in—its own currency—it doesn’t make sense to say they are “taking” something (let alone “confiscating” it as Austrians would have you believe). Instead, it’s more like they are pumping it, taking money in and forcing it back out continuously. And just as pumping doesn’t take away water but rather makes it flow, taxation and spending doesn’t remove money from the economy but rather maintains its circulation. Now that I’ve said what they get right, what do they get wrong? Basically they focus too much on money, ignoring the real economy. They like to use double-entry accounting models, perfectly sensible for money, but absolutely nonsensical for real value. The whole point of an economy is that you can get more value out than you put in. From the Homo erectus who pulls apples from the trees to the software developer who buys a mansion, the reason they do it is that the value they get out (the gatherer gets to eat, the programmer gets to live in a mansion) is higher than the value they put in (the effort to climb the tree, the skill to write the code). If, as Modern Monetary Theorists are wont to do, you calculated a value for the human capital of the gatherer and the programmer equal to the value of the goods they purchase, you’d be missing the entire point.

My name is Patrick Julius. I am about halfway through a master’s degree in economics, specializing in the new subfield of cognitive economics (closely related to the also quite new fields of cognitive science and behavioral economics). This makes me in one sense heterodox; I disagree adamantly with most things that typical neoclassical economists say. But in another sense, I am actually quite orthodox. All I’m doing is bringing the insights of psychology, sociology, history, and political science—not to mention ethics—to the study of economics. The problem is simply that economists have divorced themselves so far from the rest of social science.

Another way I differ from most critics of mainstream economics (I’m looking at you, Peter Schiff) is that, for lack of a better phrase, I’m good at math. (As Bill Clinton said, “It’s arithmetic!”) I understand things like partial differential equations and subgame perfect equilibria, and therefore I am equipped to criticize them on their own terms. In this blog I will do my best to explain the esoteric mathematical concepts in terms most readers can understand, but it’s not always easy. The important thing to keep in mind is that fancy math can’t make a lie true; no matter how sophisticated its equations, a model that doesn’t fit the real world can’t be correct.

This blog, which I plan to update every Saturday, is about the current state of economics, both as it is and how economists imagine it to be. One of my central points is that these two are quite far apart, which has exacerbated if not caused the majority of economic problems in the world today. (Economists didn’t invent world hunger, but for over a decade now we’ve had the power to end it and haven’t done so. You’d be amazed how cheap it would be; we’re talking about 1% of First World GDP at most.)

The reason I call it “infinite identical psychopaths” is that this is what neoclassical economists appear to believe human beings are, at least if we judge by the models they use. These are the typical assumptions of a neoclassical economic model:

Perfect information: All individuals know everything they need to know about the state of the world and the actions of other individuals.

Rational expectations: Predictions about the future can only be wrong within a normal distribution, and in the long run are on average correct.

Representative agents: All individuals are identical and interchangeable; a single type represents them all.

Perfect competition: There are infinitely many agents in the market, and none of them ever collude with one another.

“Economic rationality”: Individuals act according to a monotonic increasing utility function that is only dependent upon their own present and future consumption of goods.

I put the last one in scare quotes because it is the worst of the bunch. What economists call “rationality” has only a distant relation to actual rationality, either as understood by common usage or by formal philosophical terminology.

Don’t be scared by the terminology; a “utility function” is just a formal model of the things you care about when you make decisions. Things you want have positive utility; things you don’t want have negative utility. Larger numbers reflect stronger feelings: a bar of chocolate has much less positive utility than a decade of happy marriage; a pinched finger has much less negative utility than a year of continual torture. Utility maximization just means that you try to get the things you want and avoid the things you don’t. By talking about expected utility, we make some allowance for an uncertain future—but not much, because we have so-called “rational expectations”.

Since any action taken by an “economically rational” agent maximizes expected utility, it is impossible for such an agent to ever make a mistake in the usual sense. Whatever they do is always the best idea at the time. This is already an extremely strong assumption that doesn’t make a whole lot of sense applied to human beings; who among us can honestly say they’ve never done anything they later regretted?

The worst part, however, is the assumption that an individual’s utility function depends only upon their own consumption. What this means is that the only thing anyone cares about is how much stuff they have; considerations like family, loyalty, justice, honesty, and fairness cannot factor into their decisions. The “monotonic increasing” part means that more stuff is always better; if they already have twelve private jets, they’d still want a thirteenth; and even if children had to starve for it, they’d be just fine with that. They are, in other words, psychopaths. So that’s one word of my title.

I think “identical” is rather self-explanatory; by using representative agent models, neoclassicists effectively assume that there is no variation between human beings whatsoever. They all have the same desires, the same goals, the same capabilities, the same resources. Implicit in this assumption is the notion that there is no such thing as poverty or wealth inequality, not to mention diversity, disability, or even differences in taste. (One wonders why you’d even bother with economics if that were the case.)

As for “infinite”, that comes from the assumptions of perfect information and perfect competition. In order to really have perfect information, one would need a brain with enough storage capacity to contain the state of every particle in the visible universe. Maybe not quite infinite, but pretty darn close. Likewise, in order to have true perfect competition, there must be infinitely many individuals in the economy, all of whom are poised to instantly take any opportunity offered that allows them to make even the tiniest profit.

Now, you might be thinking this is a strawman; surely neoclassicists don’t actually believe that people are infinite identical psychopaths. They just model that way to simplify the mathematics, which is of course necessary because the world is far too vast and interconnected to analyze in its full complexity.

This is certainly true: Suppose it took you one microsecond to consider each possible position on a Go board; how long would it take you to go through them all? More time than we have left before the universe fades into heat death. A Go board has two colors (plus empty) and 361 spaces. Now imagine trying to understand a global economy of 7 billion people by brute-force analysis. Simplifying heuristics are unavoidable.

And some neoclassical economists—for example Paul Krugman and Joseph Stiglitz—generally use these heuristics correctly; they understand the limitations of their models and don’t apply them in cases where they don’t belong. In that sort of case, there’s nothing particularly bad about these simplifying assumptions; they are like when a physicist models the trajectory of a spacecraft by assuming frictionless vacuum. Since outer space actually is close to a frictionless vacuum, this works pretty well; and if you need to make minor corrections (like the Pioneer Anomaly) you can.

However, this explanation already seems weird for the “economically rational” assumption (the psychopath part), because that doesn’t really make things much simpler. Why would we exclude the fact that people care about each other, they like to cooperate, they have feelings of loyalty and trust? And don’t tell me it’s because that’s impossible to quantify; behavioral geneticists already have a simple equation (C < r B) designed precisely to quantify altruism. (C is cost, B is benefit, r is relatedness.) I’d make only one slight modification; instead of r for relatedness, use pfor psychological closeness, or as I like to call it, solidarity. For humans, solidarity is usually much higher than relatedness, though the two are correlated. C < p B.

Worse, there are other neoclassical economists—those of the most fanatically “free-market” bent—who really don’t seem to do this. I don’t know if they honestly believe that people are infinite identical psychopaths, but they make policy as if they did.

These kinds of statements would only make sense if markets were really as efficient and competitive as neoclassical models—that is, if people were infinite identical psychopaths. Allow even a single monopoly or just a few bits of imperfect information, and that whole edifice collapses.

And indeed if you’ve ever been unemployed or known someone who was, you know that our labor markets just ain’t that efficient. If you want to cut unemployment payments, you need a better argument than that. Similarly, it’s obvious to anyone who isn’t wearing the blinders of economic ideology that many large corporations exert monopoly power to increase their profits at our expense (How can you not see that Apple is a monopoly!?).

This sort of reasoning is more like plotting the trajectory of an aircraft on the assumption of frictionless vacuum; you’d be baffled as to where the oxidizer comes from, or how the craft manages to lift itself off the ground when the exhaust vents are pointed sideways instead of downward. And then you’d be telling the aerospace engineers to cut off the wings because they’re useless mass.

Worst of all, if we continue this analogy, the engineers would listen to you—they’d actually be convinced by your differential equations and cut off the wings just as you requested. Then the plane would never fly, and they’d ask if they could put the wings back on—but you’d adamantly insist that it was just coincidence, you just happened to be hit by a random problem at the very same moment as you cut off the wings, and putting them back on will do nothing and only make things worse.

Can otherwise intelligent people really believe that these insane models are true? I’m not sure.
Sadly I think they may really believe that all people are psychopaths—because they themselves may be psychopaths. Economics students score higher on various psychopathic traits than other students. Part of this is self-selection—psychopaths are more likely to study economics—but the terrifying part is that part of it isn’t—studying economics may actually make you more like a sociopath. As I study for my master’s degree, I actually am somewhat afraid of being corrupted by this; I make sure to periodically disengage from their ideology and interact with normal people with normal human beliefs to recalibrate my moral compass.

Of course, it’s still pretty hard to imagine that anyone could honestly believe that the world economy is in a state of perfect information. But if they can’t really believe this insane assumption, why do they keep using models based on it?

The more charitable possibility is that they don’t appreciate just how sensitive the models are to the assumptions. They may think, for instance, that the General Welfare Theorems still basically apply if you relax the assumption of perfect information; maybe it’s not always Pareto-efficient, but it’s probably most of the time, right? Or at least close? Actually, no. The Myerson-Satterthwaithe Theorem says that once you give up perfect information, the whole theorem collapses;even a small amount of asymmetric information is enough to make it so that a Pareto-efficient outcome is impossible. And as you might expect, the more asymmetric the information is, the further the result deviates from Pareto-efficiency. And since we always have some asymmetric information, it looks like the General Welfare Theorems really aren’t doing much for us. They apply only in a magical fantasy world. (In case you didn’t know, Pareto-efficiency is a state in which it’s impossible to make any person better off without making someone else worse off. The real world is in a not Pareto-efficient state, which means that by smarter policy we could improve some people’s lives without hurting anyone else.)

The more sinister possibility is that they know full well that the models are wrong, they just don’t care. The models are really just excuses for an underlying ideology, the unshakeable belief that rich people are inherently better than poor people and private corporations are inherently better than governments. Hence, it must be bad for the economy to raise the minimum wage and good to cut income taxes, even though the empirical evidence runs exactly the opposite way; it must be good to subsidize big oil companies and bad to subsidize solar power research, even though that makes absolutely no sense.

No neoclassical model says that you should privatize prisons; prisons are a classic example of a public good, which would be underfunded in a competitive market and basically has to be operated or funded by the government.

No neoclassical model would support the idea that the EPA is a terrorist organization (yes, a member of the US Congress said this). In fact, the economic case for environmental regulations is unassailable. (What else are we supposed to do, privatize the air?) The question is not whether to regulate and tax pollution, but how and how much.

No neoclassical model says that you should deregulate finance; in fact, most neoclassical models don’t even include a financial sector (as bizarre and terrifying as that is), and those that do generally assume it is in a state of perfect equilibrium with zero arbitrage. If the financial sector were actually in a state of zero arbitrage, no banks would make a profit at all.

In case you weren’t aware, arbitrage is the practice of making money off of money without actually making any goods or doing any services. Unlike manufacturing (which, oddly enough, almost all neoclassical models are based on—despite the fact that it is now a minority sector in First World GDP), there’s no value added. Under zero arbitrage, the interest rate a bank charges should be almost exactly the same as the interest rate it receives, with just enough gap between to barely cover their operating expenses—which should in turn be minimal, especially in a modern electronic system. If financial markets were at zero arbitrage equilibrium, it would be sensible to speak of a single “real interest rate” in the economy, the one that everyone pays and everyone receives. Of course, those of us who live in the real world know that not only do different people pay radically different rates, most people have multiple outstanding lines of credit, each with a different rate. My savings account is 0.5%, my car loan is 5.5%, and my biggest credit card is 19%. These basically span the entire range of sensible interest rates (frankly 19% may even exceed that; that’s a doubling time of 3.6 years), and I know I’m not the exception but the rule.

So that’s the mess we’re in. Stay tuned; in future weeks I’ll talk about what we can do about it.